This application discloses an invention that is related, generally and in various embodiments, to enhanced financial products, systems, and methods for providing a certain level of principal protection in order to truncate the downside risk of an investment in a portfolio.
Many investors are interested in principal protection for truncating downside risk from an investment program. Classical principal protection is well established, with many insurers and investment managers globally actively marketing the product. One technique for providing principal protection involves purchasing one or more securities together with put options or stop loss orders on such securities. Another technique is to purchase a portfolio and enter into a portfolio insurance strategy under which an investment manager uses an algorithm that attempts to dynamically replicate a put on part or all of the portfolio if the value of the portfolio declines.
Some techniques can be implemented when there is an options market for the securities or when futures can be used to dynamically hedge an asset class, such as principal protection on an investment in the S&P 500.
A common method to provide principal protection is “constant proportion portfolio insurance (CPPI)”. This method of principal protection is to enter into a principal protected note or other arrangement with an insurer or other provider. The provider in turn uses a portion of the initial principal to purchase a zero-coupon bond or other low risk investment for the term of protection and invests the remainder directly or indirectly in the portfolio to be protected. The income from the zero-coupon bond or other investment is designed to offset most potential losses in the portfolio over the term of protection. If the portfolio begins to lose more than expected, the insurer or other provider begins selling some of the portfolio to limit the magnitude of additional downside risk.
CPPI depends upon the ease of de-levering, which in turn depends upon an adequately liquid underlying portfolio and an adequately long term (e.g., 5-10 years) for the zero-coupon bond or other low risk investment to generate offsetting income. Insurers typically want a meaningful part of the underlying portfolio to have very short-term liquidity and low volatility, together with a sufficiently long term of protection.
The traditional techniques for providing principal protection are not able to provide principal protection over short periods of time (e.g., less than three years) for an underlying portfolio that does not have significant monthly liquidity (e.g., certain types of fund of hedge funds). Accordingly, there exists a need for enhanced financial methods, products, and systems for providing some level of principal protection for such situations.